17 May 2004 10:00
Opinion: Inside View - Ensuring carbon emission proposals are more than hot air
ByLine: Neil Murray
Following the European Union's acceptance of the Kyoto Protocol proposals, carbon emissions have come to the
forefront of investors' minds. The proposals encourage the cleaner burning of fossil fuels and the increased
production of environmentally friendly energy. This is of particular relevance for the utility sector.
While the Kyoto Protocol of 1997 has not been ratified (Russia needs to accept the protocol to gain the required 50%
approval) the EU is committed to reducing overall greenhouse gas emissions by 8% from the 1990 levels by 2008. Within
the EU, application of the protocol produces huge disparities at the national level. France does not have to make any
reductions, while Germany must reduce emissions by 21%. Each government must produce a National Allocation Plan to
address how they will effect the reductions and some countries, such as the UK, are targeting reductions even greater
than those required by the Protocol. The first phase, from 2005-07 encompasses only Carbon Dioxide (CO2), while in the
second phase, 2008-12, all greenhouse gases will be converted into an equivalent of CO2 and will be included in the
targets.
The Kyoto Protocol does not only affect utilities - it also includes other industries that produce large amounts of
CO2. However, because there has not been global acceptance of the Protocol (in particular, the US has refused to sign
up) firms that are affected by the protocol are likely to be at a competitive disadvantage, particularly against US
companies. This suggests that industries that do not export and produce significant levels of emissions, such as power
utilities, will have to bear most of the burden of the new regulations.
So how will this new legislation affect companies and power utilities in particular? Each company will be given a
maximum level of CO2 that they may produce and if they exceed this target they will be fined E40 per tonne of CO2
produced in phase one, and E100 in phase two. Companies which emit less than their CO2 quota will be able to sell this
capacity through the emissions market to those in deficit. What is not known yet is at what price this market will
settle on, and just how expensive this will be.
Will there be credit rating downgrades for companies as a result of the Protocol? This will very much depend on a
number of factors. Firstly, it will depend on what allocations are given to the companies by each individual government.
In the first phase this is likely to be relatively accommodative; however in the second phase, when companies have had
the chance to gain experience, the allocations are likely to be more restrictive. Secondly, it will depend on how much
of the cost of compliance companies will be able to pass on to customers. Power utilities, as quasi monopolies, are
likely to be more successful than companies in general in this regard. Most at risk are the power utilities that rely on
coal for a large proportion of their generation, such as RWE or Endesa. Electricity de France, on the other hand,
generates mostly from nuclear plant and is likely to gain from the new regulation.
If companies are emitting more CO2 than allowed under their allocation, their next consideration is whether to buy
credits through the carbon trading market or whether it is more cost efficient to use other means. One option is to
build new plant that emits less CO2 and its equivalents, such as gas turbines, or develop renewable generating plant
like wave or wind turbines. Oddly, companies can build renewable or cleaner production outside the EU and then use these
credits against their domestic production, which they will do if they can build plant more cheaply in another country
than the can domestically. They also have the option of investing in current coal plant to reduce flue emissions. There
are obviously many inputs that will determine the long run price per tonne of CO2, but the maximum is likely to be set
by the cost of building new gas generating plant.
To further complicate matters in the UK, the government has set itself targets for the production of green power. The
main milestones being 10% of generation to come from renewables by 2010 and 20% by 2020. A market has been established
to trade Renewable Obligation Certificates (ROCs) through which companies can sell on their green power production, if
they have more than they require. This market will help to facilitate the reduction of CO2 emissions through electricity
generation but the build cost is high and power production is weather dependent.
Little is yet known about the implementation of the Protocol; in fact, the first deadline for the production of
National Allocation Plans was the end of March 04 which was missed by many European countries. However, we are working
hard to assess the companies we invest in for the likely impact of this major shift in the operating environment.
Neil Murray is investment manager, corporate bonds at Scottish Widows Investment Partnership
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